Behaving irrationally during stressful markets can unknowingly make you a speculator.
There’s a big difference between outguessing the market and “being the market.”
Research shows that fear of loss is twice as powerful as the thrill of a gain.
A market loss is only real if you hit the sell button and get out.
With all the volatility and uncertainty in today’s markets you’d think that every investor would admit they don’t know what is going to happen from one day to next. Despite all the evidence to the contrary, too many investors still think they can guess correctly.
We all get the same news and watch the same market performance, but no one can really say with any certainty whether the market is going to go up or down tomorrow. That’s because the market is completely random. Eugene Fama received the 2013 Nobel Prize in economics for proving that markets adjust instantaneously to all available information. Yet many folks still think they can beat the rest of the market to a valuable piece of information that no one else has. It’s simply not true, but people keep trying.
Speculators believe they can outguess the market. Unlike speculators, true investors use information, research and data to be the market. There is a big difference between being the market and outguessing the market.
Experience has shown that most people who are willing to put their money into the market call themselves “investors.” But more often than not they behave like “speculators” from time to time. They act on impulse and move their money based on what they think the market‐‐or a particular stock‐‐is going to do in the future. But since the future is unpredictable, these efforts are futile and will lead to investment failure. Most people who put their money into the market see only two choices:
1. One, is to pull out of the market entirely and invest in other types of assets. This requires you to take all your money off the table. You neglect any future growth in your portfolio, hoping the alternative asset classes will perform over time. It is possible to be successful in commodities, real estate, currency speculation and more. But, investing in these types of assets requires a skill and talent most people do not possess.
2. Leave your money invested in the market and watch the market go up and down. When the market goes down, (and it will), you will feel like you lost your bet. But if the market goes up, you will feel like you won your bet because you stayed in the game. You made the right decision and you benefited from the calculated “risk” you took by not liquidating your portfolio.
Taking a step back for a second, realize that neither position is particularly rational. Many people allow their investment performance to determine their overall well‐being. This can be brutal.
If you think about it, the majority of investors struggle with behaviors that we commonly associate with gamblers. Their fear of loss and their exhilaration from gain drives their investment decisions. These powerful emotions are what most gamblers feel at the slot machine or card table. They do not serve the investor very well over time. Nobel Laurate Daniel Kahneman (author of Thinking, Fast and Slow) discovered through extensive testing that the sadness of loss impacts investors twice as much as the joy of gain does. The fear of loss is a much stronger emotion than the euphoria of winning. This would explain the heavy burden of fear that swamps most investors when they see a strong market correction. It’s what drives them to cut their losses and liquidate.
Is there an alternative? How can an investor avoid the fear associated with down markets? If you are an INVESTOR, you want to look at the long run and say to yourself, “Markets go up and markets go down. Somewhere along the way I am going to have to accept the fact that my account lost money‐‐but only if I liquidate and only for a little while.”
History has shown that market loss is temporary, but only for true investors. For speculators, market loss is permanent. Once you liquidate your holdings and sell for less than you paid, then the loss is permanent. Investors are still affected emotionally by any market decline. No one likes to see their portfolio value go down in value. But when it does, it means you are not going to let your emotions drive you to pull out of the market and then try to guess when to get out and when to get back into the market.
Everyone has to answer this simple question, to their own satisfaction … Are you an investor or are you a gambler?
Source: First Trust Advisors
The chart above will give you some clues about how markets really work. What do you see? It is mostly blue‐‐i.e. bull markets dating back to the 1920s? Look at the red – the down markets. Obviously, the 1930s were pretty terrifying. But overall – which makes more sense? Sell. Accept the losses and then start over some day in the future? Or, ride out the ups and downs and benefit from the many blue periods that inevitably follow the red?
Gamblers try to avoid the red, but in doing so they miss out on a significant part of the blue. By contrast, investors endure the red periods and benefit from all of the blue periods. Multiple studies have determined that investors earn on average much less than the market has earned over the same period.
The lesson here is: Don’t’ be a gambler; be an Investor. Don’t let the market chaos dictate your investment decisions. You need an investment process based on research, historical data, hypothesis testing and historical evidence. Rely on this process to bring you through the roller coaster ride that accompanies the market.
In Part 2 of this series, we’ll look closer at developing a process you can stick to for long periods of time, no matter what the market throws at you.
We are here to help.